Southern's Dividends May Not Last Forever

Evaluating the sustainability of dividend payments.

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Oct 26, 2010 at 12:00AM

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Not only do companies that have quarterly or annual payouts provide you with a steady stream of income, they also have the potential for capital appreciation. Simply put, dividend stocks can give your portfolio what almost no other investment can -- both income and growth.

At The Motley Fool, we're avid fans of dividends -- and not just because we like that steady stream of cash. Studies have shown that from 1972 to 2006, stocks in the S&P 500 that don't pay dividends have earned an average annual return of 4.1%; dividend stocks, however, have averaged a whopping 10.1% per year. That is an incredible difference -- one that you'd be crazy to not take advantage of!

But investing in dividends can be dangerous -- companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warnings signs that may alert you, and these red flags could be the crucial factor in determining whether a company is likely to continue paying its dividend. Today, let's drill beneath the surface and check out Southern Co.(NYSE: SO).

What's on the surface?Southern, which operates in the electric utilities industry, currently pays a dividend of 4.70%. That's certainly nothing to sneeze at, as the average dividend payer in the S&P 500, in 2009, sported a yield of 2%.

But what's more important than the dividend itself is Southern's ability to keep that cash rolling. The first thing to look at is the company's reported dividends versus its reported earnings. If you happen to see dividend payments that are growing faster than earnings per share, it may be an initial signal that something just isn't right. Check out the graph below for details of the past five years:

Source: Capital IQ, a division of Standard & Poor's

Clearly, there doesn't seem to be a problem here. Southern has been able to boost its earnings at an adequate pace and keep its dividends in check at the same time.

The more secure, the betterOne of the most common metrics that investors use to judge the safety of a dividend is the payout ratio. This number tells you what percentage of net income is paid out to investors in the form of a dividend. Normally, anything above 50% is cause to look a bit further. According to the most recent data, Southern's payout ratio is 70.17%. Southern is obviously paying out a substantial portion of its net income in the form of a dividend. This isn't necessarily a bad thing -- companies can increase their payout ratios over time, possibly because they are becoming more mature, or possibly because that's the best way to increase shareholder value. What's important is if there's enough cash on hand to support that high payout ratio, so let's look at free cash flow.

Free cash flow -- all the cash left over after subtracting out capital expenditures -- is used by firms to make acquisitions, develop new products, and of course, pay dividends! We can use a simple metric called the cash flow coverage ratio, which is cash flow per share divided by dividends per share. Normally, anything above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. Southern's coverage ratio is 0.24, which isn't enough to make me feel comfortable as an investor. There could be a number of reasons the number is so low -- maybe it's typical for the industry, maybe there's a significant amount of debt coming due, or maybe Southern is simply less than stellar at managing its assets.

Either way, it's always beneficial to compare an investment with its most immediate competitors, so in the chart below, I've included the above metrics with those of Southern's closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Southern can illustrate that it's grown dividends over the past five years then there's a good chance that it will continue to put shareholders first in the future. Check out how Southern stacks up below:

Company

Dividend

Yield

Payout

Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

Southern

4.70%

70.17%

(0.24)

4.11%

Exelon(NYSE: EXC)

5.00%

53.02%

1.57

5.61%

Duke Energy(NYSE: DUK)

5.50%

185.99%

(0.12)

(2.69%)

NextEra Energy(NYSE: NEE)

3.60%

42.83%

(2.78)

6.95%

Source: Capital IQ, a division of Standard & Poor's.

The Foolish bottom lineOnly you can decide what numbers you're comfortable with in the end; sometimes a higher yield and a higher reward mean additional risk. However, when we look at Southern's payout ratio compared to its peer average, we see that it is a lower percentage, which illustrates that its dividend is probably more sustainable. Out of this small bunch, Exelon certainly seems to emerge from the pact as having the most sustainable dividend. The bottom line, however, is to make sure that with anything -- whether it be a dividend, a share repurchase, or an ordinary earnings report -- you do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.